3-1

Accounting
What the Numbers Mean
CHAPTER 3: Fundamental
Interpretations Made from
Financial Statement Data
Marshall, McManus, and Viele
12th Edition

3-2
 Learning Objectives
After studying this chapter, you should understand and be able to:
LO3-1: Discuss why financial statement ratios are important.
LO3-2: Explain the importance and show the calculation of return on investment.
LO3-3: Illustrate how to calculate and interpret margin and turnover using the DuPont model.
LO3-4: Explain the importance and show the calculation of return on equity.
LO3-5: Explain the meaning of liquidity and discuss why it is important.
LO3-6: Discuss the significance and calculation of working capital, the current ratio, and the acid-test
ratio.
LO3-7: Generalize about how trend analysis can be used most effectively.

3-3
 Financial Ratios and Trend Analysis
• A ratio is simply the relationship between
two numbers.

• The large dollar amounts reported in the

financial statements of many companies, and
the varying sizes of companies, make ratio
analysis the only sensible method of evaluating
various financial characteristics of a company.

Learning Objective 3-1: Discuss why financial statement ratios are important. 3-4
 Trend Analysis
Trend analysis compares a single
observation over several years.

Trend analysis example: Suppose a student’s grade point

average for last semester was 3.5 on a 4.0 scale. That
GPA may be interesting, but it says little about the
student’s work. However, suppose you learn that this
student’s GPA was 1.9 four semesters ago, 2.7 three
semesters ago, and 3.0 two semesters ago. The upward
trend of grades suggests that the student is working
“smarter and harder.” 

Learning Objective 3-1: Discuss why financial statement ratios are important. 3-5
 Rate of Return
Rate of Amount of return
=
return Amount invested
This ratio provides the return on a given
investment alternative. All other things being
equal, the higher the rate of return, the more
profitable the alternative.
The rate of return calculation is derived
from the interest calculation.
Interest = Principal × Rate × Time
Higher rates of return are associated
with greater risk.
Learning Objective 3-2: Explain the importance and show the calculation of return on investment 3-6
 Return on Investment (ROI)
Return on Net income
=
investment Average total assets

The ROI of a firm describes the rate of

return that management was able to earn on
the assets it had available to use during the
year.
An informed judgment about the firm’s
profitability requires relating net income to
the assets used to generate that net income.

Learning Objective 3-2: Explain the importance and show the calculation of return on investment 3-7
 Return on Investment (ROI)

Return on Operating income

=
investment Average operating assets

Some financial analysts prefer to use income from

operations (or earnings before interest and income
taxes) and average operating assets in the ROI
calculation.

Learning Objective 3-2: Explain the importance and show the calculation of return on investment 3-8
 The DuPont Model
Return on Net income Sales
investment
=
Sales
× Average total assets

Margin Turnover

The DuPont model is an expansion of the

basic ROI calculation.
The developers of the model reasoned that
profitability from sales and utilization of
assets to generate sales revenue were both
important factors to be considered when
evaluating a company’s overall profitability.

Learning Objective 3-3: Illustrate how to calculate and interpret margin and turnover using the DuPont model. 3-9
 The DuPont Model
Return on Net income Sales
investment
=
Sales
× Average total assets

Margin Turnover

Emphasizes that Relates to the

from every dollar efficiency with
of sales revenue, which the firm’s
some amount assets are used
must work its in the revenue-
way to net generating
income process
Learning Objective 3-3: Illustrate how to calculate and interpret margin and turnover using the DuPont model. 3 - 10
 The DuPont Model
Return on Net income Sales
investment
=
Sales
× Average total assets

Margin Turnover

A rule of thumb useful for putting ROI in

perspective is that for most American
merchandising and manufacturing
companies, average ROI based on net
income ranges between 8 percent and 12
percent.

Learning Objective 3-3: Illustrate how to calculate and interpret margin and turnover using the DuPont model. 3 - 11
 Return on Equity (ROE)
Return on Net income
=
equity Average stockholders' equity

Stockholders are interested in expressing

the profits of the firm as a rate of return on
the amount of stockholders' equity.

A rule of thumb for putting ROE in

perspective is that average ROE for most
American merchandising and
manufacturing companies has historically
ranged from 12 percent to 18 percent.
Learning Objective 3-4: Explain the importance and show the calculation of return on equity.
3 - 12
 Measures of Liquidity
Liquidity refers to a firm’s ability to meet its current
obligations and is measured by relating its current assets
and current liabilities as reported on the balance sheet.

Liquidity is measured in
three principal ways:

• Working Capital

• Current Ratio

• Acid-Test Ratio
Learning Objective 3-5: Explain the meaning of liquidity and discuss why it is important. 3 - 13
 Working Capital

Working capital is the excess of a firm’s

current assets over its current liabilities.

Learning Objective 3-6: Discuss the significance and calculation of working capital, the current ratio, and the acid-test ratio. 3 - 14
 Current Ratio
Current = Current assets
ratio Current liabilities

This ratio is most useful in

judging a company’s current
bill-paying ability.

As a rule of thumb, a current ratio of

2.0 is considered indicative of
adequate liquidity.

Learning Objective 3-6: Discuss the significance and calculation of working capital, the current ratio, and the acid-test ratio. 3 - 15
 Acid-Test Ratio
The acid-test ratio is also known as the quick ratio.

Acid-test Cash (including temporary

=
ratio cash investments) +
Accounts receivable
Current liabilities

Learning Objective 3-6: Discuss the significance and calculation of working capital, the current ratio, and the acid-test ratio. 3 - 16
 Trend Analysis
A trend analysis is an evaluation of selected data over time.
Remember our student’s grades example at the beginning of this presentation?

This table illustrates the trend analysis of return on

investment, return on equity, and working capital for
Campbell Soup over a five-year period.
TABLE 3.1 CAMPBELL SOUP COMPANY (PROFITABILITY* AND LIQUIDITY DATA,† 2013–2017)
2017 2016 2015 2014 2013
Margin (net earnings‡/net sales) 11.2 7.1 8.2 10.5 8.8

Turnover (net sales/average total assets) 1.01 1.00 1.00 1.01 1.09
ROI (net earnings/average total assets) 11.4 7.1 8.2 10.6 9.6
ROE (net earnings/average total equity) 55.8 38.7 44.7 62.0 67.8
Year-end position (in millions):
Current assets $1,900 $1,908 $2,093 $2,100 $2,221
Current liabilities   2,395 2,555 2,806 2,989 3,282
Working capital (495) (647) (713) (889) (1,061)
Current ratio 0.79 0.75 0.75 0.70 0.68

Learning Objective 3-7: Generalize about how trend analysis can be used most effectively. 3 - 17
 Trend Analysis

Trend analysis
can be used to
construct graphs
so that trends
over time can be
seen.

Learning Objective 3-7: Generalize about how trend analysis can be used most effectively. 3 - 18
 Trend Analysis

Learning Objective 3-7: Generalize about how trend analysis can be used most effectively. 3 - 19